Model portfolios come down to one thing: allocation. By using a model, investors can allocate across a variety of asset classes in a set proportion. This keeps the risk of the portfolio within targets and delivers returns in all types of markets. But building a model can be difficult. Asset classes all perform differently. But there may be one that performs a multitude of duties for a model portfolio.
We’re talking about dividend stocks.
Dividend stocks can offer plenty of benefits to a model portfolio, including income potential, downside protection, and lower volatility. With benefits in mind, adding a dedicated dose of dividends to a model can enhance its overall returns and diversification benefits. The best part of adding dividends to a model is that it’s a breeze.
A Dividend Investing Strategy
In today’s fast-paced world of 24-hour trading, $0 commissions, and gains-obsessed culture, we forget that when you buy a stock, you’re buying an ownership stake in a company. As such, you’re entitled to a share of the firm’s profits. Some firms use profits to buy back shares and boost the value of an owner’s stake in the company. But many others hand over a portion of their cash each quarter as a dividend.
Dividend investing as a strategy is when an investor focuses part or all of their portfolio on these stocks. This can be via individual equities or via ETFs, mutual funds, and other investment vehicles that hone in on dividend-paying equities.
And while there are many varieties of dividend investing, the style basically falls into two camps: high-yield and dividend growth.
As the name suggests, high-yield dividend investors will generally target companies that pay dividends in excess of the broader market or sectors. The yield drives much of the return component for a portfolio.
Dividend growth focuses on firms that have long histories of increasing their payouts. The consistent increase in payout can provide proof of fundamental quality. This in turn can drive share prices higher and a total return element, with dividend yield and capital appreciation combining for a portfolio.
Why Focus on Dividends?
So why cast a lens toward dividend-paying stocks? The answer is multi-pronged.
For starters, dividends have long been a key portion of the market’s total returns throughout its history. Since the 1930s, dividends have accounted for roughly 41% of the market’s total returns. That’s a significant portion of the actual gains in a portfolio. This chart from Nuveen underscores how dividends have driven returns during various time periods.
Source: Nuveen
Second, dividend stocks have provided ballast to a portfolio during periods of duress. Because steady dividend payers’ constituency return cash to their shareholders, they tend to not move around as much and feature lower volatility than non-dividend paying stocks. This provides lower correlation to the broader market. Additionally, the cash return of dividend equities can help turn losses into gains. After all, getting 3% in cash can turn a down or flat year into a positive one.
Moreover, dividends have been powerful inflation fighters. Corporations are typically able to pass on cost increases to consumers and other businesses in most cases. This keeps profits humming in periods of inflation. Dividend stocks have long been able to reward their shareholders during this time. The win comes down to dividend growth rates. Historically, the rate at which stocks in the S&P 500 have increased their dividends per year has been just under 6%. That rate is more than double the long-term average for inflation.
Another win for dividends? Tax efficiency. Qualified dividends are taxed at low rates, usually 15% or lower for most investors. By focusing on dividends, investors can still reap good quarterly returns while not facing Uncle Sam’s wrath.
Dividend Stocks in a Model Portfolio
With the benefits of dividend investing, the question is how they perform in a model portfolio and their function. The answer, like their benefits, is mulit-faceted.
Dividend stocks can serve as a bridge between equities and bond allocations. They can generate steady income and provide some ballast when economic conditions deteriorate, just like a fixed income sleeve. And they can do so at lower tax rates: ordinary income vs. the 15% cap. At the same time, they are equities and can produce a steady return just like the broader market, albeit with lower volatility.
The powerful combination and ability to straddle the line between stock/bond allocations can have powerful diversification benefits and create a steady, consistent positive return over the long haul.
Now, dividend stocks aren’t perfect and can fall when the broader market tanks out. However, they tend to be less affected compared to non-dividend-paying stocks. And that’s key for fighting the sequence of withdrawal risks over the long haul. Meanwhile, the steady cash payments help drive returns in such scenarios as well.
So how to work them into a model? Analysts suggest investors have anywhere from as little as 5% to as much as 60% of their portfolios weighted toward dividend stocks. Ultimately, those with more conservative risk profiles may want to go heavier on the allocation to grab the most benefits from these equities. However, no matter what the percentage, adding a dedicated dividend sleeve could pay some serious benefits to a portfolio.
In the case of models, dividend equities are easy to access via ETFs and various mutual funds. Advisors and investors can quickly add scale and allocation percentages with a single ticker.
Dividend ETFs & Mutual Funds
These funds are selected based on their exposure to dividend stocks, both passive and active management styles. They are sorted by YTD total return, which ranges from -1.6% to 16.5%. They have expense ratios between 0.06% and 0.62%, while their AUM is between $2B and $83B. They are currently yielding between 1.2% and 3%.
| Ticker | Name | AUM | YTD Total Ret (%) | Yield | Exp Ratio | Security Type | Actively Managed? |
|---|---|---|---|---|---|---|---|
| CGDV | Capital Group Dividend Value ETF | $2.86B | 16.5% | 1.7% | 0.33% | ETF | Yes |
| VIG | Vanguard Dividend Appreciation Index Fund ETF | $83.8B | 7.4% | 1.9% | 0.06% | ETF | No |
| PRDGX | T. Rowe Price Dividend Growth Fund | $22.5B | 7.3% | 1.2% | 0.62% | MF | Yes |
| FEQTX | Fidelity® Equity Dividend Income Fund | $5.91B | 5.3% | 3% | 0.58% | MF | Yes |
| DGRO | iShares Core Dividend Growth ETF | $24.6B | 4.4% | 2% | 0.08% | ETF | No |
| VYM | Vanguard High Dividend Yield ETF | $63B | 0.8% | 2.9% | 0.06% | ETF | No |
| SDY | SPDR S&P Dividend ETF | $22.6B | -1.6% | 2.6% | 0.35% | ETF | No |
Ultimately, dividend stocks are wonderful tools for model portfolios. They can provide many bond-like and stock-like attributes to an investment plan. This includes steady income, lower volatility, and even lower taxes. That’s a win, win, win for investors of all sizes.
Bottom Line
Dividend stocks are a major win for model portfolios. Providing plenty of benefits, dividend stocks can help balance out a model, providing elements of both growth and safety. With that in mind, adding a dedicated sleeve of dividend equities to a model makes a lot of sense.
